Dizard on Rating Agencies, Old and New

There has been an enormous amount of fulminating about rating agencies, yet they solider on, their status still secure even if their reputations are considerably tarnished.

John Dizard in today’s Financial Times adds some grist that is likely new to many readers. He discusses how the rating agencies operated before the SEC created the “Nationally Recognised Statistical Rating Organisation” designation in the 1970s that created a considerable barrier to entry and was accompanied by some behavioral changes. He also discusses the prospect for Egan-Jones, newly approved as a ratings agency. While some of Dizard’s story covers familiar territory, he does it with such color and verve I thought it worth including as well.

From the Financial Times:

This is the time of year when incentive compensation is calculated and distributed. Or would have been distributed, I should say, in the case of loss-making trading desks and hedge funds. Naturally, there is no greater object of obsession in the financial world than one’s bonus. Everyone agrees that’s why you get up early, leave late, and keep the payer’s interests in mind.

For some reason, though, there’s one group of rats in the maze that are supposed to ignore the cheese when they turn this way or that. I refer to the leading ratings agencies, led by Moody’s, Standard & Poor’s and Fitch, which are paid by the issuers to serve the interests of the buyers. Even after the structured credit markets, designed with their endorsement, have been kicked into flinders before our eyes, we’re supposed to believe that their compensation structure has had no influence on their thinking. Any sitting judge who has a mutual fund or unit trust with a few shares in a party’s company will recuse himself from the case or face censure.

Yet even now, the agencies blithely assume they can continue with this charade. Last week, in a paper from Moody’s called “Archaeology of the Crisis”, written by Pierre Cailleteau, the firm’s international economist, it was pointed out that: “In plain English, it is not clear that existing compensation mechanisms effectively ensure that traders take into account the long-term interests of the bank for which they work, ie its survival.” Mr Cailleteau went on to say: “Ratings agencies were supposed to bridge some of the information asymmetries [in subprime securitisation], but this proved to be somewhat unrealistic when the incentive structure of [subprime] loan originators, subprime loan borrowers and market intermediaries also shifted in favour of less information.”

Something missing in that list, perhaps? Such as the “incentive structure” of the ratings agencies themselves? Their compensation only lasted as long as the flow of the defective issuers. When it slowed and finally stopped, their own earnings and stock price went into reverse.

So far, the established agencies have refused to consider the possibility of changing their own compensation structures. However, on December 21 the US Securities and Exchange Commission finally agreed to license the Egan-Jones ratings agency as what it calls a “Nationally Recognised Statistical Rating Organisation”. Egan-Jones, based in Philadelphia, does not accept any compensation from the issuers whose paper it rates; the revenue comes from the subscribers to its service, mostly buy-side firms.

Sean Egan, chief executive, first applied for NRSRO status 11 years ago. That “licence”, originally devised by the SEC to anoint firms that would determine the adequacy of broker-dealers’ capital, became the safe harbour for fiduciaries worried about being punished for picking a bad bond issue. If the agencies said it was “investment grade”, it wasn’t your fault if it failed to pay out.

Oddly, while the agencies had been around for decades, it was only when they acquired official licences in the 1970s that their compensation system shifted overwhelmingly to issuer-pays. When their compensation was based on market choice, rather than official imposition, they had more incentive to come up with ratings that served the interests of the buyers.

It was on this sand that the multi-trillion securitisation industry was founded. And, in fairness, it worked as you would expect after studying rodents seeking food pellets.

This isn’t to say that it is desirable, or even possible, to go back to a system where credit is dispensed by bank credit committees or old boys’ bond market networks. There just aren’t the people, structures or capital available in the banking system to do that. Some form of third party that rates risk and allocates tranches of risk among appropriate parties is inherently more efficient.

Mr Egan doesn’t plan to rate American municipal issuers, which had been a base business of the established firms. “The core of the whole debacle was the rating of structured securities. S&P and Moody’s have failed so miserably at this that I am now sure we can do a better job.” While Egan-Jones has analysts for corporate and bank issuers, it still needs systems for structured securities ratings.

So far, it’s only the housing-based securitisation market that’s frozen up, with the commercial real estate securities starting to ice over. Problems are beginning for credit card and auto paper, and securitisations of corporate paper have not really hit the wall. But we’re early in the cycle.

European buyers were cheerful enablers of the ratings-driven securitisation mess, but they may lead reforms. Mr Egan says: “In general, European officials are more open to looking at alternatives, because S&P and Moody’s, as well as the major broker-dealers, are based in the US more than in Europe. European institutions are suffering the pain from paper that gets downgraded from AAA to D within a month.” But the agencies were paid perhaps a couple of million dollars for rating mid-sized structured issues. As we now see, being paid by the wrong people.